Saturday, January 29, 2011

Irrational Exuberance: Chapter 3

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

In this chapter, Shiller discusses the amplification mechanisms involving investor confidence and expectations that he believes are contributing in a major way to the speculative stock bubble of the year 2000. He argues that these amplification mechanisms work through a positive feedback loop, reinforcing each other until what he predicts will be a stock price collapse.

First, Shiller establishes through survey evidence that investor confidence has indeed increased in the late 1990's as compared to other periods. For example, groups of investors expected higher stock returns in the future than similar groups had in the past.

He then discusses why this may have happened, suggesting that regret (from not participating in the recent gains), a tendency to extrapolate short-term results into the long-term, the recounting of stories of those who have made riches in the market, and a tendency to ignore inflation (and therefore think of nominal stock returns only, which have been much higher than real returns over time) are leading to investor confidence that is currently higher than it should be.

Currently (at the time of writing, in the year 2000), Shiller argues that as prices continue to rise, investor confidence and expectations are going through a feedback loop. Higher stock prices are leading to higher expectations which are leading to higher prices. Shiller calls this process a naturally occuring Ponzi scheme: investors are presented with a plausible story about how great profits will be made (the reasons discussed in Chapter 2), they start by investing small, and as their returns rise, they become willing to invest more and more money. The payoffs to the investors come entirely from new money that is entering the market! A fraudulent manager isn't even required for this natural Ponzi scheme to grow wildly.

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